When it comes to saving the question of “where should I save my money” is a popular and important question. Typically the showdown of best account is between the Roth and Pre-Tax (traditional) accounts.
While each account has its merits and if you still aren’t sure after reading this plus don’t want to seek professional advice… flipping a coin and going with either account is better than not picking at all!
This is the first post on comparing the two types of accounts. Our focus here is exclusively on a Roth account.
Roth accounts can be a Roth IRA or a Roth 401(k). The difference?
An IRA is Individual Retirement Account that you open and manage yourself. You can hire a third party manager to assist you in selecting the appropriate investments, but this account is one you open up personally.
A 401(k) is an employer sponsored retirement account. You can only contribute to the account when you are an employee. If you’re no longer employed by the company sponsoring the 401(k) you can roll your 401(k) into an IRA.
What is a Roth IRA or Roth 401(k)?
The term Roth is used to designate an account as:
- A retirement savings account with…
- Contributions that have been previously taxed
- Followed by tax free withdrawals.
Point number two is similar to how you put money into your piggy bank, checking, or savings account. You will pay income, social security, and Medicare tax on that money before it enters those accounts.
Other than the fact that that a Roth is a retirement account it also differs from a savings account in that the money invested inside the account grows tax free. As you earn interest, dividends, or capital gains on the money you don’t pay tax on the growth.
The most important feature that makes a Roth so attractive is that when you take money out of the account you will not pay tax on the money you receive. That tax shelter applies to both the amount you put in (principal) and the gain (appreciation) on that money you invested.
Example: You invested $100 into a Roth account. It grows to $1,000. You have $900 of growth and $100 on principal. When you decide to take the full $1,000 out of the account none of that money is taxed.
A Roth account is a Tax Free Withdrawal Account.
Like many things in finance and nearly everything in tax there are a few exceptions regarding the Tax Free Withdrawal Account. Going into detail on these is beyond the scope of this article, but in general you must:
- Be 59 1/2 or older to withdraw interest, dividends, gains from the account
- AND 5 years must pass from when the first contribution is made to ANY Roth IRA to access gains on the account
- Not withdraw conversions for 5 years (includes principal!)
When to contribute to a Roth
When choosing to contribute to a Roth the general idea is that you are contributing to a Roth because you expect your tax rate to be higher in the future.
Remember, by contributing to a Roth you are paying tax now, not when you take the money out. This means that you are making the decision that your tax rate today is lower than tomorrow’s tax rate. You’re forgoing today’s tax deduction for no tax tomorrow. For example:
Looking at your current year tax return as a single filer you see that you have $36,000 of taxable income, which puts you in the 15% tax bracket. Because you have high career aspirations you fully expect to be a high earner in the future. Using a financial calculator you project that you will save enough to have $50,000 a year to spend in retirement before adjusting for inflation. This means you will be in the 25% tax bracket. Knowing this means contributing to a Roth makes sense because you are in a lower tax bracket today then you anticipate to be in the future.
Alternatively, if you are in the 25% tax bracket today and expect to be in the same bracket tomorrow then you can make your best guess whether or not tax brackets will increase in the future. If you think they will then your argument for a Roth makes a lot of sense.
The downside is that it’s really hard to make these guesses. Unless you have a crystal ball it’s impossible to know for sure, so the general recommendation is that you should contribute to a Roth early in your career.
Ultimately, the tax timing game comes into play later in life when you may have an opportunity to take advantage of Roth conversions. It’s much clearer what your tax rate will be as you near retirement.
Why Roth IRAs are the best
Generally you will be advised to play the tax rate prediction game to determine whether you should contribute to a Roth account. However, the real reason that Roth IRAs are the best is simple.
Roth = Flexibility.
When contributing directly to a Roth IRA you are eligible to withdraw the contributions at any time. Yes, that means if you contributed $5,000 and decide you need that money to start a business (or any other reason) you have immediate access to the money.
You’re not allowed to take out earnings on the amount you contributed. This must stay in the account until you’re 59 1/2 or you will be subject to a 10% penalty.
Having the flexibility to take out distributions any time is a huge benefit. It allows you to consistently maximize your contributions without worry that you won’t have access to that money prior to age 59.5. For many reasons this can trump the tax benefits associated with a Roth versus Traditional option.
A Roth is the best retirement savings account because it provides the most flexibility of any of the accounts. Important to note is that a Roth 401(k) has similar rules as a regular 401(k), but after you finish employment you can move your Roth 401(k) into a Roth IRA where you can receive the same level of freedom.
Another reason that a Roth IRA is the best is the fact that you are not subject to taking Required Minimum Distributions. That means you can allow that money to grow your entire life without worries that you’ll need to pre-maturely withdrawal the money due to the required draw down rules that Traditional accounts have.
In retirement there will be some people who will have more money saved than they need. Leaving a Roth IRA as an inheritance is an amazing, tax-free gift.
If you look beyond the tax deduction now versus tax free distribution later part of the equation you will see why Roth’s are the best.
Visit the IRS website to learn the current rules on how much and when you can contribute to a Roth IRA: https://www.irs.gov/retirement-plans/roth-iras
Do you want to understand how to make your money work for you and keep more of what you have earned?
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Nate Byers a Madison, WI CPA Financial Advisor, and all rights are reserved. Read the full Disclaimer in the footer below.